Section 108 of the Internal Revenue Code Relief of Indebtedness Income and WorkoutsOne of the most overlooked areas of the law when doing a workout is Section 108 of the Internal Revenue Code (“IRC”). Section 108 is a trap for the unwary and unless the attorney or lawyer is aware of this tax code section, it can upend a workout or result in a taxpayer having to recognize, report, or pickup unknowingly a significant amount of taxable income. This could ruin the attorney-client relationship or worse yet a malpractice lawsuit by the client against the attorney.
Let's begin this post with an explanation of Section 108 of the IRC.
IRC § 108 provides that if an individual or an entity that owes money (the “Debtor”) is relieved of indebtedness, then that indebtedness is deemed to be ordinary income to the Debtor. The Debtor must report that income on their tax return and the Creditor is required to file a 1099 with the IRS. There are two exceptions to this rule: first, if the Debtor files for bankruptcy protection, then the relief of indebtedness income is not picked up; and second, on a balance sheet basis, if the individual’s liabilities exceed their assets and they are insolvent, then they do not have to pick up the income.
The goal of a workout from the perspective of the Debtor (the person who owes money) is to pay less than the balance due to the Creditor (person or company owed money).
An example of the application of IRC § 108 will help to explain the above. Let’s assume that an individual owes a financial institution $1,000,000. The individual is unable to pay the $1,000,000, so the parties enter into a workout (an out of court settlement) in which the individual repays the financial institution $600,000. According to IRC § 108, the taxpayer must pick up the $400,000 differential between what he or she owed and paid as ordinary income.
Unless the client is made aware of this fact in advance of or during a workout, the client may walk away from the workout. If not told at all, when the client receives the 1099 from the Creditor or worse gets audited by the IRS, they will point a finger at the attorney or sue the attorney for malpractice.
Many clients and some lawyers assume that the $400,000 of income is capital gains, but it is ordinary income.
Another question raised by clients is how does the IRS find out about this relief of indebtedness income? The answer is that the Creditor is required to file a Form 1099-C with the IRS reporting the relief of indebtedness income for more than $600 of forgiven debt.
Yet another question asked by clients is whether the Creditor will file the 1099 with the IRS? The answer is that the Creditor is legally required to do so and most institutional investors will do the 1099 filing.
Section 108 of the IRC comes up in almost every workout, but is currently most prevalent in taxi medallion and restaurant workouts. Both of these industries are struggling and are areas we are doing a lot of workouts.
Clients should review all workouts with their CPA’s or accountants.
At Shenwick & Associates, we are not tax lawyers, but we are familiar with the IRC and James Shenwick has an LLM in Taxation from the NYU School of Law.
Clients who are doing or contemplate doing a workout, are encouraged to consult with James Shenwick to discuss their strategy. Jim Shenwick 212 541 6224 firstname.lastname@example.org